October 30, 2013, by Malvika Johal
My guide to starting your own business – Part 9
Written by: R L (Bob) Hall (BSc, PhD; University of Nottingham) Owner and MD of Top and Jeffries Limited; Co – owner & Chairman of Fuel Additive Science Technologies Limited, Shropshire, UK
You probably did not want to read this, but you need to get to grips with the technical aspects of a business. You need this not only to understand how your business is performing, but to ensure your accountant is providing you with the right service and to have credibility with any potential future lenders. I will not get into a full explanation in this paper, but the following are important to understand:
- Work with your accountant to figure right from the start how you are going to pay yourself. This can either be by salary, directors loan (payment back for start-up money you have personally put in) or by interim dividends (a tax and national insurance efficient way of paying yourself).
- Cash flow (or cash in the bank) is the most critical parameter to both monitor and model forward daily – cash in and out of the bank account. A sales order may be overall profitable, but the business may not be able to afford the cash required to buy the raw materials and pay the wages to fulfill the order until the payment from the customer arrives into the bank account. In fact taking on such a “profitable” order may sink the company. I still check cash flow, every day, for my businesses.
- Profit is sanity, turnover is vanity. Net profit is what determines the overall “health” of a business. Most businesses are valued by a specific variation of net profit called EBITDA (Earnings Before Income Tax Depreciation and Amortization). Various multiples of EBITDA are used to value a business depending upon industry sector and whether it is a public or private company
- The official company books contain lots of financial information ordered in a particular way. They are, however, only a snapshot of the company’s situation. Sales, expenditure and profit are relatively easy to understand, but get your accountant to explain what all the variables on the balance sheet mean. You will see how this changes as the company grows. There is an official accountancy definition of assets and liabilities which is strictly defined. You need to understand them, but also need to create your own definitions of assets and liabilities for your company wearing your hat as the owner/operator of the money making machine. For example, one of my businesses is labour intensive and uses a lot of small low cost equipment that is easy to maintain, cheap to replace and rarely goes wrong. My accountant views the whole of that business as having a very low amount of tangible assets. Whereas if we had bought a large machine to do the same work, that would have quite a considerable tangible asset book value. To me, as the business owner, having such a large machine would be a total liability as I would have had to find a lot of money to buy it and to justify its existence I would worry if it was not utilized any less than 100%. So you can see how something that is a large tangible asset in “accountancy speak” could in fact be a complete liability in “money making business machine owner speak”.
- Capital expenditure. The funds to buy such a large machine described above would be classed as capital expenditure. With these types of purchases for equipment that has an effective life of several years, the cost is spread across many years of company books. In general, it is a good thing to minimize these purchases especially in the early months of a business start-up. This series continues in the coming weeks to discuss all the pitfalls and best practice advice available when setting up a business. I wish someone really had shared these things with me 25 years ago and I hope those entrepreneurs among our alumni community are feeling inspired. Next in the series discusses the all-important subject of support.
Keep a look out for the next in the series which discusses support.